The plucking model, the great recession, and Austrian business cycle theory.

Murphy, Ryan H.

JEL CLASSIFICATION: B53, E32

Milton Friedman's "Plucking Model" (Friedman, 1993) has been used to argue against the relevance of theories of the "boom" preceding economic downturns, such as Austrian Business Cycle Theory (ABCT) According to Friedman, output data show that economies follow a trend, with recessions being temporary setbacks prior to a return to a trend approaching the economy's maximum feasible output. Economies do not substantially go over trend during a boom; they collapse and then return to trend. Recessions "pluck" output downwards, but booms do not have similar effects in the opposite direction, as shown in Figure 1. Therefore, busts are what is to be explained, not the boom. While defenders of ABCT have objected to this interpretation (e.g. Garrison 1996), it remains an effective rhetorical point among macroeconomists.

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However, despite the unemployment rate in the United States falling to 5.8 percent as of October 2014 following the Great Recession, RGDP has not returned to its "potential," i. e., Friedman's maximum feasible output This contradicts the historical record which Friedman highlighted as fatal for ABCT Figure 2 provides actual and potential RGDP in the United States since 2002 (data from FRED). From 2008-2009, RGDP fell off significantly in comparison to its potential, and while it has grown since then, it did not snap back to potential as predicted by the plucking model.

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These data for potential RGDP assume that the economy was not overheating during the boom. If we grant the possibility that an ABCT boom was happening in the middle of the first decade of the millennium, then an altogether different picture emerges. Figure 3 compares actual RGDP against the assumptions that potential RGDP increased 1.5 percent, 1.75 percent, and 2 percent per year, starting in 2002. Under any of those assumptions (especially the middle case), the boom is clear and the modest growth rates we experience now are merely reflective of what is possible today given the US economy's fundamentals.

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In the context of the plucking model, recent data do not reject ABCT. If anything, the data behave exactly as ABCT predicts--or at least how Friedman conceived of ABCT predicting. The reason for the importance of this point is the revival of interest in ABCT from mainstream economists, as documented by Cachanosky and Salter (2013). These mainstream economists, including Caballero (2010), Diamond and Rajan (2009), and Taylor (2009) each have made the argument that, of all recessions of recent memory, the Great Recession most clearly fit the stylized predictions of ABCT.

If these economists were correct, that this recession was a departure from the patterns of others, then it stands to reason that economies would cease behaving in accordance to the plucking model, which is precisely what has happened This is not in any way the "Texas sharpshooter fallacy," where after the fact the "test" of a theory is defined so that the theory passes; the plucking model has been one of the primary rationales as to why ABCT was dismissed by macroeconomists.

It may be a coincidence that the first time in nearly a century mainstream economists recognized how well the stylized predictions of ABCT fit a recession was also the first time in recent memory that the plucking model failed to hold Perhaps in the coming years the US will experience rapid growth, and the pluck of the Great Recession was just a very large, slow pluck. Or it is perhaps the case that the Great Recession is the clearest example of an Austrian Business Cycle we have on record, and the data bear that out.

REFERENCES

Cachanosky, Nicolas, and Alexander W. Salter. 2013. "The View from Vienna: An Analysis of the Renewed Interest in the Mises-Hayek Theory of the Business Cycle. " Working paper, available at http:// papers.ssrn.com/sol3/papers.cfm?abstract_id=2363560.

Caballero, Ricardo J. 2010. "Macroeconomics after The Crisis: Time to Deal with the Pretense-of-Knowledge-Syndrome. " Journal of Economic Perspectives 24, no. 4: 85-102.

Diamond, Douglas W., and Raghuram G. Rajan. 2009. "The Credit Crisis: Conjectures about Causes and Remedies." American Economic Review 99, no. 2: 606-610.

Friedman, Milton. 1993. "The 'Plucking Model' of Business Cycle Fluctuations Revisited. " Economic Inquiry 31, no. 2: 171-177.

Garrison, Roger. 1996. "Friedman's 'Plucking Model': Comment. " Economic Inquiry 34, no. 4: 799-802.

Taylor, John B. 2009. Getting Off Track. Stanford: Hoover University Press.

Ryan H. Murphy (rhmurphy@smu.edu) is Research Associate at The O'Neil Center for Global Markets and Freedom at SMU Cox School of Business.